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Liability limits: lessons from the BP oil spill

One year ago, the BP Deepwater Horizon drilling rig exploded, killing 11 crew members and sending more than four million barrels of oil into the Gulf of Mexico. Although drilling in the Gulf’s deep waters is resuming, several of the policies contributing to the BP disaster remain in place. Notably, the law limiting oil companies’ liability for the damage they cause has yet to be changed. Similar laws shield oil companies in Canada. Until lawmakers eliminate these liability caps, oil companies will lack full incentives to prevent future disasters, and will be ill-equipped to deal with them should they occur.

The National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling – established to determine the causes of the oil spill and to propose reforms to make offshore drilling safer – traced the spill to “a series of identifiable mistakes … that reveal such systematic failures in risk management that they place in doubt the safety culture of the entire industry.” A culture of complacency, marked by missed warning signals and a general lack of appreciation for the risks involved, was years in the making. The result: inadequate investments in safety, containment, and response equipment and practices.

The Commission found that one explanation of the oil industry’s complacency lies in the liability limitations that shield it from full responsibility for the harm it does. The US Oil Pollution Act of 1990 set a $75 million cap on liability for damages resulting from oil spills (unless the oil company violated a federal safety regulation or was grossly negligent). Such a cap reduces a company’s incentives to take care and encourages risky behaviour. It thus increases the likelihood of accidents.

The Commission explained: “A threshold problem with any damages cap that limits liability well below levels that may actually be incurred is that such a cap distorts the incentives of industry participants to adopt cost-effective safety precautions. Decisions regarding safety precautions are made for a variety of reasons, some of which cannot be influenced by policy measures. The relatively modest liability cap and financial responsibility requirements provide little incentive for oil companies to improve safety practices.” Fran Ulmer, one of the commissioners, put this criticism of the liability cap into plainer language just last week: “When companies look at such a low amount, it factors into how much money they’re willing to spend to reduce the risk.”

In addition to deterring investments in safety, liability limits may leave ecosystems unrepaired and victims uncompensated should an accident occur. The $75-million cap, complains one US Senator, “is just a spit in the ocean.” The costs of the BP spill have exceeded this amount by orders of magnitude. To its credit, BP waived the statutory cap – the company is reported to be spending at least $41 billion in clean-up costs and damages. But many other companies would be unable or unwilling to foot such a bill. The Commission pointed out that another party responsible for a future spill might not have sufficient resources to fully compensate for potential damage, and, even if it did, might not agree to waive the statutory cap. In such an event, taxpayers and the victims of the spill could well be on the hook for substantial costs. These parties, the Commission argued, should not have to “pay the bill for industry’s shortcomings.”

Leaving taxpayers and victims holding the bag is not only unjust – it is also bad economics. Shifting costs from the oil industry to the public constitutes an enormous subsidy, lowering industry costs, giving oil an advantage over safer alternatives, boosting demand, and ultimately, artificially encouraging production.

Liability limits are as likely to pervert energy decisions here in Canada as they are in the US. Regulations under the Canada Oil and Gas Operations Act limit liability for spills in waters under federal jurisdiction, with a cap ranging from $10 million to $40 million, depending on the location. Two “accord acts” establish the same liability limits for off-shore drilling in Nova Scotia and Newfoundland. The Marine Liability Act limits ship owners’ liability for oil pollution, based on their cargo capacity. Nor is the oil industry alone in enjoying protection from liability. In the event of an accident at a nuclear power plant, Canada’s Nuclear Liability Act exempts designers and manufacturers from all liability and limits the liability of operators to $75 million. (A bill increasing liability for nuclear accidents to $650 million died on the Order Paper when the Parliamentary session ended last month.)

Only by restoring unlimited liability can we begin to sort out what forms of energy are the safest and most affordable. And only by requiring energy producers to obtain insurance commensurate with the risks their operations pose – or otherwise prove that they have the financial capacity to meet their obligations – can we ensure that energy firms meet the demands not only of those who regulate them, but also of those who underwrite them. As law professor Richard Epstein writes, “Solid insurance underwriting is likely to do a better job in pricing risk than any program of direct government oversight.” The result is a system, he explains, that “sorts out the wheat from the chaff – so that … companies with weak safety profiles don’t get within a mile of an oil derrick…. Only strong players, highly incentivized and fully bonded, need apply for a permit to operate.”